Have you ever heard coworkers talking around the water cooler about a hot tip on a bond? We didn't think so. Tracking bonds can be about as thrilling as watching a chess match, whereas watching stocks can have some investors as excited as NFL fans during the Super Bowl. However, don't let the hype (or lack thereof) mislead you. Both stocks and bonds have their pros and cons. This article will explain the advantages of bonds and offer some reasons as to why you may want to include them in your portfolio.
A Safe Haven for Your Money
Those just entering the investment scene are usually able to grasp the concepts underlying stocks and bonds. Essentially, the difference can be summed up in one phrase: debt versus equity. That is, bonds represent debt and stocks represent equity ownership.
This difference brings us to the first main advantage of bonds: In general, investing in debt is safer than investing in equity. The reason for this is the priority that debtholders have over shareholders. If a company goes bankrupt, debtholders are ahead of shareholders in the line to be paid. In a worst-case scenario, such as bankruptcy, the creditors (debtholders) usually get at least some of their money back, while shareholders often lose their entire investment.
In terms of safety, bonds from the U.S. government (Treasury bonds) are considered "risk-free" (there are no "risk-free" stocks). While not exactly yielding high returns (as of 2012, a 30-year bond yielded an interest rate of 2 to 3%), if capital preservation - which is a fancy term for "never losing your principal investment" - is your primary goal, then a bond from a stable government is your best bet. However, keep in mind that although bonds are safer as a rule, that doesn't mean they are all completely safe. There are also very risky bonds, which are known as junk bonds.
Slow and Steady - Predictable Returns
If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle. It's not unusual for stocks to lose 10% or more in a year, so when bonds make up a portion of your portfolio, they can help smooth out the bumps when a recession comes around.
There are always conditions in which we need security and predictability. Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire two years into a bear market. By owning bonds, retirees are able to predict with a greater degree of certainty how much income they'll have in their golden years. An investor who still has many years until retirement has plenty of time to make up for any losses from periods of decline in equities.
Better Than the Bank
Sometimes bonds are just the only decent option. The interest rates on bonds are typically greater than the rates paid by banks on savings accounts. As a result, if you are saving and you don't need the money in the short term, bonds will give you a relatively better return without posing too much risk.
College savings are a good example of funds you want to increase through investment, while also protecting them from risk. Parking your money in the bank is a start, but it's not going to give you any return. With bonds, aspiring college students (or their parents) can predict their investment earnings and determine the amount they'll have to contribute to accumulate their tuition nest egg by the time college starts.
How Much Should You Put into Bonds?
There really is no easy answer to how much of your portfolio should be invested in bonds. Quite often, you'll hear an old rule that says investors should formulate their allocation by subtracting their age from 100. The resulting figure indicates the percentage of a person's assets that should be invested in stocks, with the rest spread between bonds and cash. According to this rule, a 20-year-old should have 80% in stocks and 20% in cash and bonds, while someone who is 65 should have 35% of his or her assets in stocks and 65% in bonds and cash.
That being said, guidelines are just guidelines. Determining the asset allocation of your portfolio involves many factors, including your investing timeline, risk tolerance, future goals, perception of the market and income. Unfortunately, exploring the various factors affecting risk is beyond the scope of this article.
The Bottom Line
Misconceptions about bonds abound, but the fact is that bonds can contribute an element of stability to almost any portfolio. Bonds are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are a great savings vehicles for when you don't want to put your money at risk.